What is volatility?
Volatility is a statistical measure of the dispersion or variance of returns for a given security or market index from the overall average. Traditionally, it is thought that the higher the variance from the mean stock price, the more risky the investment is. That’s because if the security fluctuates more over a larger range of values, the price is more difficult to predict.
Consider cyclical stocks for example — they are more volatile because they are affected by the market (particularly recessions) more so than non-cyclical stocks where prices stay relatively steady.
KEY TAKEAWAYS
- Volatility refers to the amount of movement surrounding a particular asset
- A stock is considered more risky if the variance from the mean stock price is high
- You can minimize your risk in a volatile market by diversifying your assets
- Changes in inflation trends, company performance, and sector performance are some of the key determinants of volatility
- Whilst volatility is commonly associated with risk, it is actually vital in order for you to make money on your investments
What factors determine volatility in stocks?
Changes in inflation trends, company performance, and sector performance are some of the key determinants of whether a security is volatile or not. If, for example, the government decides to place import tax on specific goods, the security price of those goods will likely decrease.
Other factors, such as changes in economic policy, will also lead the markets to react violently. A good example is when banks decide to increase interest rates to prevent people from spending more during a period of inflation. Naturally, the markets react, and security prices drop significantly.
In particular, there is a lot of uncertainty now surrounding the War in Ukraine — whether it is escalating or not, how far Russia is planning on going, how presidents, NATO, the EU, and private companies are responding to the ongoing events. All these sorts of uncertainties are reflected in the markets as well.
Is volatility good?
It might seem counterintuitive, but in order to be a successful investor, you need volatility in the market. Yes, volatility is risky and can lead to losing money if not handled properly, but you need it in order to make significant returns on your investments. How would you make returns if prices stayed relatively steady?
You can minimize your risk in a volatile market by diversifying your assets and researching your companies inside out. It’s up to you whether to play it safe and whether a volatile security suits your portfolio.